My Chung - President and CEO Dale Messick - Chief Financial Officer

Greg Greenberg - Private Investor

Good day, ladies and gentlemen, and welcome to the third quarter 2011 Luna Innovations Incorporated earnings conference call. [Operator instructions.] I would now like to turn the conference over to your host for today, Mr. Dale Messick, chief financial officer. Please go ahead sir.

Thank you very much operator. Good afternoon everyone and thank you for taking the time to join us today as we review our progress and results for the third quarter of 2011. Before we go further, let me remind each of you that statements made in this conference call and our public filings, releases, and websites, which are not historical facts, may be forward-looking statements that involve risks and uncertainties and are subject to change at any time, including, but not limited to, statements about future financial or operating performance or management transition and future research contract awards. We caution investors that any forward-looking statements made by us are management’s beliefs based on currently available information and should not be taken as a guarantee of future results or performance, which may differ materially as a result of a variety of factors discussed in our earnings release and our latest form 10-Q filed with the Securities and Exchange Commission. We disclaim any obligation to update any such factors or to announce publicly the result of any revisions to any of the forward-looking statements to reflect future events or developments. There is more complete information regarding forward-looking statements, risks, and uncertainties in the company’s filings with the SEC available on our website. At this time, I’d like to turn the call over to My Chung, president and CEO of Luna Innovations.

Thank you Dale. For today’s call, I will briefly cover our recent successes and then provide greater insight into the direction we intend to take the company over the next several years. We realized a significant milestone in the third quarter by achieving our first quarter of profitability since the IPO in 2006. I am especially excited and proud of the team’s accomplishment in a very challenging economic time. By capturing new revenue opportunities in our secure computing group, and increasing our focus on billable projects, we were able to exceed the expectations that we set at the beginning of the quarter. The work in our secure computing group was able offset a decline in sales of our test and measurement equipment. As I discussed on our prior call, we had very strong product sales with our predominantly telecom customers in the first half of the year, but began to see activity levels and new orders softening late in the second quarter and into the third quarter. That weakness in demand did in fact continue throughout the third quarter. While we have seen some hints of optimism in this sector of our business, I believe that the fourth quarter will continue to be a challenging environment for telco-related product sales. Our shape-sensing development projects with Intuitive Surgical and Hansen Medical continue to progress as planned, with the achievement of critical milestones in terms of accuracy and resolution. At this time, I would like to turn the call back over to Dale to complete our discussion of third quarter results, and after that I will come back to our strategic growth initiatives.

Thanks My. As My mentioned already, the real financial highlight for the third quarter of 2011 is our positive net income. We realized a net income to common shareholders for the quarter of approximately $222,000, or $0.02 per basic share and $0.01 per fully diluted share compared to a loss of $517,000, or $0.04 a share, in the third quarter of last year. Revenues grew 3% overall to $8.8 million, led by a $1.1 million, or 23% increase in our technology development segment. This increase in technology development revenue was recognized in our secure computing group and our optical sensing group. With our product and license segment, revenues declined 25% to $2.7 million in the third quarter of 2011, compared to $3.6 million in the third quarter of last year. Within this segment, product sales declined $1.1 million, or 40%, compared to the same period last year due to softer demand for test and measurement equipment in the telecom area. Offsetting that decline, our commercial product development revenue increased by approximately $250,000, or 27%, compared to Q3 of last year, with the greatest growth coming from work performed under the Hansen development agreement. Our overall gross margin stayed relatively flat at 39.5% to 40% in the third quarter of both 2011 and 2010, with offsetting factors from our business segments. Technology development margins improved from 30% in the third quarter of last year to 41% in the third quarter of 2011, due primarily to new fixed price contracts recognized by our secure computing group where we were able to capture higher margins. The gross margin recognized in our product and license segment declined from 55% in the third quarter of 2010 to 36% in the third quarter of this year. The decline in overall margin for this segment is primarily attributable to the decline in product sales which typically carry our highest gross margin. Product sales accounted for 58% of the revenues in this segment in the most recent quarter, compared to 74% of the segment revenues in the third quarter of last year. In addition, earlier this year, we amended our commercial development agreement with Hansen Medical to include somewhat reduced billing rates resulting in margin compression. While product sales activities declined in the quarter, for those sales recognized we did not see significant pressure on our margins. The decline in the product and license segment overall was primarily a mix issue. Operating expenses decreased $563,000, or 15%, to $3.2 million in the most recent quarter, compared to $3.7 million in the third quarter of last year. The decrease was comprised of a nearly $1.1 million decrease in SG&A expenses offset by a $570,000 increase in research and development costs. Within SG&A, the cost decrease included a decline in our stock compensation expense of approximately $400,000, lower legal fees of approximately $240,000, and the continuing impact of the company’s overall cost reduction initiatives. R&D expenses increased to $878,000 in the third quarter of this year from $308,000 in the same quarter last year, due primarily to increased internal research and development activities in our secure computing group. You may recall from our call last quarter that at the end of Q2 and the beginning of Q3 of this year, the secure computing group had a gap between the expiration of their prior largest contract and the initiation of its related follow-on contract. During this time between contracts, the group worked largely on furthering its capabilities and tools with internal investment. Even with this period of nonbillable activity for the group, secure computing was able to increase its overall revenue for the quarter as I previously mentioned. With these activities, our results of operations reflect an operating income of approximately $313,000 for the quarter compared to an operating loss of $307,000 in the third quarter of last year and a net income of approximately $243,000 in Q3 of this year versus a net loss of $422,000 in Q3 of last year. After considering the dividend on outstanding preferred stock, our net income to common shareholders was $222,000 compared to a net loss to common of $516,000 in the third quarter of last year. Additionally, adjusted EBITDA, which is reconciled to net loss for you in the schedules included in our earnings release today, improved to $1.1 million for the third quarter of 2011 from $949,000 for the third quarter of 2010. Year to date, our net loss to common shareholders has improved to $1.1 million for the first nine months of this year compared to a net loss of $2.5 million for the first nine months of last year, an improvement of nearly 55% and representing an improvement of $0.11 per outstanding share. The bottom line improvement reflects revenue growth year to date of 8%, with both of our business segments growing on the top line and a 1.4% decrease in overall operating expenses year to date. Turning briefly to the balance sheet, we did recognize an overall decrease in our cash balance for the quarter of $1.2 million after realizing positive cash flow for each of the preceding four quarters. While we did experience a growth in revenues, a disproportionate amount of revenues were realized in the last month of this quarter and accordingly did not have time to convert from accounts receivables to cash. Our cash balance decreased by $1.2 million from June 30 to September 30, while our accounts receivable balance increased $1.2 million in that same quarter. We believe the decline in cash for the quarter is a timing issue. Looking ahead to the fourth quarter, we currently expect revenues to be in the range of $8 million to $8.5 million. This decline in revenue for the fourth quarter from the third quarter of this year reflects that our technology development segment revenues are highly dependent upon billable direct labor dollars, and we typically will recognize fewer direct labor hours during the holiday season. Additionally, the secure computing group is not expected to have the type of projects that benefit our Q3 recur until potentially some time in 2012. We currently expect product sales to increase in Q4 over Q3. However, with the continued weakness in this segment we do not expect that increase to completely offset lower technology development revenues. Accordingly, we expect our fourth quarter results to include a net loss for the quarter in the range of $0.7 million to $1 million. And with that, I’d like to turn the call back to My.

Thank you Dale. I would now like to focus the rest of the call on where we envision taking the company over the next few years. I’ve been at Luna for just over six months now, and at the very beginning of that time I told you that I would spend my first several months building a common understanding of what our key assets and capabilities are, and then developing our strategy for the future. We have completed this process, and I’ve identified three key initiatives to focus on to achieve accelerated growth over the next two to three years. Not surprisingly, these focus areas are ones where we have devoted the most attention on during our recent earnings call. The three growth initiatives are medical shape-sensing, secure computing, and distributed fiberoptic sensing systems. Our shape-sensing technology provides a substantial growth opportunity for us to capitalize on. We have been actively building this capability through our partnerships with Intuitive Surgical and Hansen Medical since 2007. We are getting this technology’s accuracy, speed, and reliability to the point required for robotic minimally invasive medical procedures. Once we have achieved the performance requirements, we will begin to put in place the quality manufacturing processes necessary to be a key supplier of these shape-sensing systems. The second focus area will be in secure computing. Here is an area that we don’t talk a lot about, but as you have heard earlier in this call, is an area where we currently have unique capabilities. Having now successfully demonstrated these capabilities, we believe that we have the opportunity to offer similar services to other government customers and to expand the scope of the services we can offer. The third focus area is in the utilization of fiberoptic sensing for measurement of temperature and strain. We believe that for applications that require multiple measurement points, optical fiber offers a significant advantage over the strain gauges employed today. With the ability to measure multiple points on a single channel, fiber offers an opportunity to reduce the costs and the complexity of installation and measurement. Initially, we will focus on the testing of composite materials, which are increasingly being used in industries such as aerospace, automotive, and energy. Last quarter we introduced the first product into this market. From our initial customer meetings, we have identified some additional technical requirements that our product will need to lead. We’re confident with these enhanced capabilities we will be well-positioned to capitalize on this opportunity. This is an initial snapshot of our strategic growth plans. Over the next quarter, we will be setting up investor meetings to share with you more details on each of these initiatives. And now I will be happy to take any questions you may have.

[Operator instructions.] Year’s fourth quarter is from the line of Greg Greenberg, and he is a private investor.

In respect to Hansen Medical and Intuitive Surgical, can you give us some idea, are those consumable products that could be sold? Or are they just systems? Or are they both, should those revenues start to come forward?

The focus that we have currently is both. Of course we will be hopefully the sole supplier on the system side, and we will be putting it in place the manufacturing processes with which to deliver the disposables at the cost point and the quality and the volumes that both of those customers are expecting.

And then I know that when it was announced earlier this year that Intuitive Surgical had extended, I guess you would say, the research agreement, or whatever it is, did that work start at that date, or had it sort of already started in January? In other words, when does this sort of annual contract renewal actually take place with Intuitive Surgical?

That contract, it was a calendar year amendment. But we started working with them back in 2007 with an agreement that lasted for two and a half years, and then we had this calendar year amendment for 2011.

And then kind of thinking about the difference between revenue that we can earn from Hansen and Intuitive Surgical, reading 10-K, 10-Q I understand that in the settlement with Hansen we gave them certain rights, but we still have the opportunity to earn significant revenue from that relationship?

That is correct.

And then just kind of a general question from sort of a shareholder item, looking through your website you have some very interesting things. I know you have a media coverage page. The last article linked there is from August 2010. I know that really there was no release or press releases since the last quarter. Any thoughts of sort of starting to get the story out, starting to let people know, as you’ve sort of, My, outlined these three key initiatives, what’s going on here as far as the growth potential?

It is. In fact, we have met with a couple of PR firms recently, with that in mind. We apologize for the lack of news, but to us it was far more important to agree on the strategic direction of the company first before we started pushing out more releases. So hopefully you’ll see something in Q1, if not the end of this quarter. We’ve already met and shared with the PR firms our strategic plan as it has been approved by the board, and we’re reviewing the proposals that they’ve put forward.

Okay, and then I’m certainly very excited about the three key initiatives that you mentioned. I guess for some point of reference, were these any different six months or 12 months ago? In other words, were there initiatives that were maybe number two or number three that got bumped off the list? What’s changed? Or are we just six months closer?

I think the key is really identifying that these are key strategic initiatives and that these are the areas that we will focus on. By that I mean make sure that they’re properly staffed, they’re properly funded, and it has the right attention from the executive team.

So this is where our resources go?

Right, exactly.

And I know you mentioned going in the future you’re going to be able to talk about each of these three key initiatives, but as you mentioned, secure computing is something that I really don’t have a good sense of what the capabilities are. Any color you can add now on that?

I’d probably defer it until later.

Okay. Last question for My, just as far as, you know, since it’s been six months, based on your expectations coming in as far as what Luna was and what Luna can be, any differences, positive or negative, now that you’ve been there for six months?

Well that’s a mixed question. [laughter] I’d say overall very positive. The capabilities from a technology standpoint far exceeded my expectation. I think the big difference is really one of deciding where do we go, and how do we really drive it forward. One of the big changes, hopefully you’ll see in the next couple of quarters, is a real change in the culture within the company. We are a company that has a high percentage of business coming from government research. We will transition that mindset over to more commercialization and more entrepreneurial.

That’s what I’m hoping for. Thank you very much.

And gentlemen, it doesn’t appear we have any more questions in the queue at this time, so I’ll go ahead and turn the call back over to you for closing remarks.

Thank you everyone again for taking the time to join us today. If you would like us to meet with you to go through a little bit more detail on the strategic initiatives, please shoot me an email or send me a message. As I said, we will be spending the next quarter doing a lot more investor relationships and PR than we have done in the past. I thank you for your support, and with that, end the call.